International funds give investors a way to invest in assets outside their home country. For an investor whose home currency is the Indian rupee, or INR, this can mean access to US, European, or other global markets.
But there is one extra factor that does not exist in the same way when you invest in local assets: currency.
Suppose you invest in a US equity fund. Your investment is linked to US stocks, but your final return in rupees also depends on the value of the US dollar against the rupee. If the dollar rises against the rupee, it can increase your return. If the dollar falls, it can reduce your return.
A currency-hedged international fund tries to reduce this currency effect. This can make the fund behave more like the foreign assets it owns. However, a hedge can also reduce a benefit that an unhedged investor may receive when the foreign currency rises.
What Is a Currency-Hedged Fund?
A currency-hedged international fund tries to separate two parts of an overseas investment: the performance of the foreign asset and the movement of the foreign currency.
For example, imagine an Indian investor puts money into a fund that owns US stocks. There are two possible sources of return. The first is the performance of those US companies. The second is the change in the USD/INR exchange rate.
An unhedged fund leaves both factors exposed. If US stocks rise and the dollar also gains against the rupee, the investor can benefit from both.
A hedged fund uses financial contracts, such as currency forwards or other derivatives, to reduce the effect of currency movements. The aim is to make the return depend more on the underlying foreign assets and less on the exchange rate.
This does not mean the currency effect will always become exactly zero. A hedge may not be perfect, and its cost can also affect the final return.
When Can a Currency Hedge Help?
A currency hedge can help when an investor wants exposure to foreign markets but does not want a large currency effect.
Consider an investor who buys a US equity fund. If the US stock market rises by 8%, that is the main investment result the investor may want to capture. But if the US dollar falls by 6% against the rupee during the same period, the currency move can reduce the return seen in rupees.
A hedge can reduce this negative effect. In simple terms, the investor gets a result that is closer to the performance of the foreign stocks themselves.
A hedge can also make sense when an investor does not want to take an extra currency position. A person may want international diversification because foreign markets have different companies, sectors, and economic conditions. In such a case, the investor may prefer to keep the currency factor smaller.
When Can a Currency Hedge Hurt?
The same hedge that protects an investor from a weaker foreign currency can also remove a useful benefit.
Suppose US stocks rise by 8%. At the same time, the US dollar becomes 10% stronger against the rupee. An unhedged Indian investor can benefit from both the rise in US stocks and the stronger dollar.
A hedged investor will largely give up the second benefit because the currency position has been covered.
This is the main trade-off. A hedge can reduce the damage from an unfavourable currency move, but it can also reduce the gain from a favourable one.
So, a hedge should not be seen as a way to create extra returns. Its main purpose is to reduce currency risk.
A Simple Example
Imagine you invest ₹1,00,000 in a US equity fund.
Suppose US stocks rise by 10%. At the same time, the US dollar becomes 8% stronger against the rupee.
For an unhedged investment, the approximate result before costs would be a gain of about 18.8%. The investor gets the 10% gain from the stocks as well as the benefit from the currency move.
For a hedged investment, the currency effect would be close to zero. The result would therefore be around a 10% gain before hedging costs and other expenses.
Now consider the opposite situation.
US stocks still rise by 10%, but the US dollar falls by 8% against the rupee.
The unhedged investment would then have an approximate return of just 1.2% before costs. The fall in the dollar would remove much of the stock-market gain.
The hedged investment could remain close to a 10% gain before hedging costs and other expenses.
This example shows why the same currency movement can have very different effects on the two types of funds.
Hedging Is Not Free
Currency hedging has a cost. Funds normally use instruments such as forward contracts or other derivatives to manage their foreign-currency exposure.
The cost can depend on several factors. These include interest-rate differences between countries, forward prices, transaction costs, market spreads, and the way the fund manages its hedge.
Because of these factors, a hedged fund can sometimes perform differently from the foreign market even when both funds own similar assets.
For this reason, investors should not assume that a currency hedge simply removes risk at no cost.
A Hedge May Not Be Perfect
Another important point is that a fund described as currency hedged does not always have a perfectly neutral currency position.
There can be a difference between the fund’s actual foreign-currency exposure and the amount covered by its hedge. The timing of the hedge can also matter.
Derivative contracts may have to be renewed or adjusted. Market conditions can also change the cost of the hedge.
As a result, some currency effect can remain even after a fund uses a hedging strategy.
The word “hedged” therefore does not mean that the investor has absolutely no currency exposure.
What About Foreign-Currency Expenses?
Your future expenses also matter.
Suppose you are an Indian investor today, but you expect to use your investment in the future for a payment in US dollars. In that case, a dollar exposure may actually be useful.
If the dollar rises against the rupee, the value of your investment in rupee terms may increase. More importantly, your investment can remain better matched with the future dollar expense.
In such a situation, automatically removing the currency exposure may not match your actual financial need.
The right choice depends on what currency you will ultimately need when you use the money.
Look Beyond Recent Returns
Investors often compare a hedged fund and an unhedged fund after a strong currency move. This can lead to the wrong conclusion.
If the dollar has risen sharply against the rupee, an unhedged fund may show a large benefit from currency. That does not mean the fund manager created a better investment result. Part of the difference came from the exchange rate.
Likewise, if the dollar falls, a hedged fund may look much better for that period. That does not mean a hedge will always produce higher returns.
The two funds simply have different currency exposure.
The better comparison is based on the investor’s goal, time horizon, risk level, costs, and desired exposure.
What Should Investors Check?
Before choosing between a currency-hedged and unhedged international fund, investors should first understand why they want overseas exposure.
If the main goal is exposure to foreign companies and markets without much currency risk, a hedged option may fit that objective.
If the investor also wants foreign-currency exposure as part of portfolio diversification, an unhedged fund may provide that exposure.
It is also important to check the fund’s hedge ratio, the method used for hedging, the cost of the strategy, and the difference between the fund’s return and its underlying market.
The holding period matters too. Currency rates can move sharply over short periods, while long-term returns can come from several different sources.
The Bottom Line
Currency hedging is neither automatically good nor automatically bad. It changes the type of risk an international investor takes.
An unhedged international fund gives exposure to both the foreign assets and the foreign currency. This can increase returns when the foreign currency rises against the home currency, but it can also reduce returns when that currency falls.
A hedged fund tries to reduce this currency effect. It can help when the foreign currency moves against the investor, but it can hurt when the foreign currency moves in the investor’s favour. Hedging also has costs and may not remove currency exposure completely.
For an INR-based investor, the key question is not simply whether the dollar will rise or fall. The more useful question is whether foreign-currency exposure is something the investor wants as part of the overall portfolio.
Once that is clear, the choice between a hedged and unhedged international fund becomes much easier to understand.
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